How Preferreds Stack Up

These hybrid investments offer high yields but significant risks

By

Jonathan Burton

May 7, 2012

Preferred-stock buyers: It pays to be choosy.

These high-yielding hybrids—not quite common stock, not quite corporate bond—appeal to income-hungry investors. But while their current 6% to 7% average yields are certainly spectacular, preferred securities and the mutual funds and exchange-traded funds that own them come with trade-offs that deserve a close look.

More in Investing in Funds

Against ordinary stock, preferreds have status. They're typically less volatile than common shares and provide a generous income stream akin to high-yield bonds. In the 2008 market meltdown, for instance, the largest preferred-stock ETF, the $8.5 billion iShares S&P U.S. Preferred Stock Index, lost about two-thirds as much as the Standard & Poor's 500-stock index, according to investment researcher Morningstar Inc.

Plus, companies must pay dividends to preferred shareholders before they pay a common-stock dividend, hence the "preferred" label. And like common-stock dividends, preferred-equity dividends typically are taxed at the favorable 15% maximum tax rate.

Know the Risks

The past few years have been, well, highly preferential for preferreds, which are most attractive when interest rates are relatively stable or declining.

ENLARGE

For example, iShares S&P U.S. Preferred Stock Index returned 22% annualized over the three years through April, boosted by its recent 6% yield and heavy tilt toward the recovering financial-services sector. That is more than two percentage points better than the S&P 500 over that time, and nearly five points above the average high-yield bond fund, Morningstar reports.

In exchange for a yield kicker, however, preferred stockholders shoulder risks that are the bane of bond investors.

For starters, preferreds are sensitive to interest rates. But unlike bonds, these securities either will never mature or in some cases will return principal only after 30 years, maybe even 50. As interest rates rise, the price of the preferred falls (and vice versa), and an investor could be stuck with lower-valued paper that a corporate issuer may never redeem.

Those rights typically include a "call" provision, where the issuer can buy out shareholders at face value after five years from the issue date. When interest rates decline, the chance of a security being called is higher because new securities can be issued at a lower yield. The opposite is true when rates rise.

Credit risk is also a concern. While many issuers of preferreds are major banks considered "too big to fail," their competitiveness in a still-struggling economy has to be considered. Troubled companies can suspend preferred dividend payments, and in a bankruptcy, preferred stockholders, unlike bondholders, are out of luck.

Holders of preferred-stock funds have to be "comfortable with the credit risk of owning financial-services securities and feel the financial sector is on its way back up," says Morningstar ETF analyst Timothy Strauts. Beware of portfolios exposed to European banks, he says.

A Good Bet?

That said, one type of preferred share commonly found in funds and ETFs should hold its edge at least a bit longer, thanks to the Dodd-Frank legislation. Under the law, banks will be prohibited after 2013 from counting a class of taxable "trust preferred" securities toward their regulatory capital requirements.

As such, it is expected that many banks will call these popular shares. Funds and ETFs, in turn, would then need to replace them with other stripes of preferreds, which could alter the funds' risk and potential return.

For now, Mr. Strauts says, the prospect of redemptions is keeping trust preferreds' prices close to their $25 par value. That presents a unique opportunity for fund managers to buy trust preferreds currently trading below par, he says, collecting an above-average yield in anticipation of the shares being called at a higher price.

Mr. Burton is the Money & Investing editor at MarketWatch in San Francisco. He can be reached atjburton@marketwatch.com.

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